What are they? How do they apply to the field of Economics?

What is an Externality? An externality is what arises when a person engages in an activity that influences the well-being of a bystander and yet neither pays nor receives any compensation for the effort.

What Types of Externalities are There? There are two types of externalities, positive and negative.

Negative Externalities Negative externalities are those which cause a negative impact on society as a whole. Causes of negative externalities include: barking dogs, factories, automobiles, etc.

What Does a Negative Externality Look Like When Applied to Supply and Demand Graphs? Because negative externalities cause a negative impact on society as a whole, the cost is actually higher than represented by just looking at the supply and demand graphs. Therefore, the supply curve shifts up to compensate for the social cost. Where the new supply curve and the demand curve intersect is the optimum price and quantity. Through free market, the price and quantity will attempt to reach equilibrium. So… how is the optimum reached?

Positive Externalities Unlike negative externalities, positive externalities cause a beneficial impact on society as whole. Causes of positive externalities include: Restoration of historic buildings, Robotics industry, education etc.

What Does a Positive Externality Look Like When Applied to Supply and Demand Graphs? Because positive externalities cause a positive impact on society as a whole, the social value is greater than the regular value, disregarding the externality, the demand curve shifts to the right. Where the supply curve and the new demand curve intersect is the optimum price and quantity. Through free market, the price and quantity will attempt to reach equilibrium. Again, the question of how to reach the optimum is contemplated.

How do you reach the optimum price and quantity? To reach the optimum, the government is needed to intervene. The government generally steps in by internalizing an externality. This is simply altering incentives so that people take account of the external effects of their actions. Internalizing a negative externality includes measures such as taxing or passing laws to discourage the production beyond the optimum quantity. For example, automobiles are issued emission standards in order to help balance the social costs of pollution. Internalizing a positive externality includes the government offering subsidies to encourage the production to the optimum quantity. For example, education receives several subsidies in order to encourage participation in educational fields so as to increase the knowledge of future governmental officials.

Private Solutions Another way for optimum price and quantity to be reached is through private solutions. For instance, when a college alumni donates funds to college of which he attended, or when a charity is established, these providers add a no cost positive externality.

Positive Externalities when Considering Technology If society can be optimized by a technological discovery, often the government will step in and provide funding for the experiment. An example of this would be the Robotics industry. If the government provides a subsidy, funds, for every robot build, it will most likely help to increase the development of the industry. This subsidy will shift the supply curve down due to the decrease in the cost to the producer due to the subsidy.

Coase Theorem The Coase Theorem simply suggests that private markets can solve problems dealing with externalities on their own if there is no cost over allocation of resources without government intervention. For example, Jim and Bill are in a disagreement over Jim’s obtrusive tree, which crosses the property line of Bill’s land. Jim’s tree gives him a benefit of $100, while Bill has a $150 cost from this tree. According to the Coase Theorem, Bill and Jim will be able to settle this disagreement through an efficient outcome of, say, $125. In this case, Bill’s cost outweighs Jim’s benefit, therefore a solution was reached. But what if the benefit outweighs the cost? What if the tree had been on Jim’s family property for years, then he might receive a $200 benefit from the tree, while the cost to Bill might still be $150. In this case, the benefit outweighs the cost, so Jim will simply not harm his tree, still an efficient outcome. If this theorem seems to work so well, what can keep it from being true for all situations?

The Answer: Transaction Costs Although it is often beneficial for the Coase Theorem to fall into action, it is often not worth the cost. For instance If many are involved in a transaction and/or deal, or a boundary is some how placed on those making a deal, a resolution is often too difficult to reach or not cost efficient. For example, Sheldon is a sticky notes salesmen who produces his products in his home. Leonard, Sheldon’s next door neighbor just happens to be conveniently allergic to sticky note glue. Let’s say that Leonard tragically lost his ability to hear, talk, smell, or feed himself in a tragic accident. Leonard is unable to communicate with Sheldon or afford someone to communicate with him. At this point, the government is forced to step in and resolve the problem.

Government Responses to Externalities The government can begin to curve the effects of externalities in one of two ways: command-and-control policies and market-based policies. This is done to reach an efficient allocation of resources. Command-and-control policies regulate directly. For example, setting a certain amount of pollution allowed to be emitted. In contrast to this form of policy, market-based policies attempt to provide an incentive to curve the effects of the externalities. For example, applying a tax on each unit of pollution emitted.

What Makes Market-Based Policies so Effective? Pigovian taxing, a form of a market-based policy, is a tax used in order to balance the negative externality effects. For example, as in pollution, a Pigovian tax is placed on each unit of pollution emitted. This causes the company to cut the amount of pollution as much as possible without hindering production in order to pay as little tax as possible. A Pigovian tax causes the supply curve to be perfectly elastic. This is because companies are allowed to produce as much as they want as long as they pay the tax.

Copyright © 2004 South-Western Quantity of Pollution 0 Price of Pollution Demand for pollution rights P Pigovian tax (a) Pigovian Tax which, together with the demand curve, determines the quantity of pollution. 1.A Pigovian tax sets the price of pollution... Q

What Makes Command-and- Control Policies so Effective? Command-and-control policies directly set a limit on production, causing the quantity to either be raised or lowered depending if it is intended to curve a positive or negative externality. In pollution, companies are allowed to trade their permits to one another. Companies that are able to lower their emissions at a low cost are more likely to sell, while companies that have a high cost of lowering their emissions are more likely to purchase permits, still lowering the emissions set by the EPA.

Copyright © 2004 South-Western Quantity of Pollution 0 Demand for pollution rights Q Supply of pollution permits (b) Pollution Permits Price of Pollution which, together with the demand curve, determines the price of pollution. 1.Pollution permits set the quantity of pollution... P

Conclusion… Externalities are simply effects on society, whether positive or negative. Externalities may be curved by resolving the issue privately (as stated by the Coase Theorem) and/or by the government through Pigovian taxes/subsidies.

Works Cited Principles of Economics content/uploads/2008/03/Mayor%20McCheese%20from%20nofunleague.jpg y.gif o_ _positive_negative_handshake.jpg Principles of Economics chapter 10 power point